Currency gains could cap Asian reserve growth: BIS

Bloomberg

Asian central banks should consider allowing more currency appreciation to contain an expansion of their balance sheets that risks spurring inflation and financial instability, the Bank for International Settlements (BIS) said.

The balance sheets of nine Asian central banks surged to US$6.4 trillion last year from US$1.1 trillion in 2010, the Basel, Switzerland-based BIS said in a report released on Sunday. A high rate of increase may strain the ability of the financial system to absorb the funds and generate price pressures, it said.

Asian nations have built up forex holdings to record levels since the 1997 to 1998 regional financial crisis to bolster confidence in their economies after the turmoil depleted their reserves and led some countries to seek IMF bailouts. The BIS said the increase in reserves since the mid-2000s was largely a result of Asian central banks resisting currency appreciation pressures generated by trade and capital flows in the region.

“The balance sheet expansion by these central banks has produced financial distortions,” Stephen Cecchetti, BIS economic adviser and head of the monetary and economic department, said in a conference call on Friday. “The fact that inflation is low and financial systems are stable now does not mean that they will necessarily remain so in the indefinite future. There are no reasons to become complacent.”

While the increase in Asian central banks’ balance sheets is not an immediate inflation risk and policymakers have been successful in the so-called sterilization of foreign-exchange purchases, large balance sheets may leave central banks vulnerable to huge financial losses and the accumulation of foreign reserves may “crowd out” domestic lending, according to the report.

“Serious consideration should also be given to capping and then shrinking the size of central bank balance sheets,” the BIS said. “Greater tolerance of currency appreciation over time could be a key element of a framework to limit further accumulation of foreign assets.”

Meanwhile, global banks scaled back cross-border lending to companies, governments and each other at the fastest rate since 2008 in the final quarter of last year, with lenders based in the euro area leading the way.

Lenders reporting to the BIS shrank their cross-border assets by US$799 billion, or 2.5 percent, in the three months ended Dec. 31, data showed. The decline was the sharpest since the fourth quarter of 2008, when interbank lending markets froze worldwide following the collapse of Lehman Brothers Holdings Inc.

“The decline was led by a significant drop in interbank lending arising from the spillover of the euro-area sovereign debt crisis to bank funding markets,” BIS said in its quarterly report. “The reduction was especially marked for cross-border claims on residents of the euro area and was mostly attributable to euro-area banks.”

Interbank lending contracted by US$637 billion during the fourth quarter, as the European debt crisis infected bank-funding markets, particularly affecting the euro’s 17 member countries, the BIS said. Cross-border claims on banks in the euro region fell US$364 billion during the period.

The Libor-OIS spread, a gauge of banks’ reluctance to lend to each other, “increased to high levels on the back of higher risk premia and the growing reluctance of market participants to engage in interbank loan transactions,” the BIS said.